How Bond ETFs May Help Your Portfolio

I talk a lot in this space about how you can use ETFs to build bond portfolios in the current market environment, and my colleague Russ Koesterich recently explored this topic as well. These applications generally leverage the exchange traded fund (ETF) benefits that many people are familiar with, namely exchange liquidity, low bid/offer spreads and tax efficiency. Today I want to talk about another ETF application that I have been getting a lot of questions from investors about recently: using ETFs for manager transition.

Let’s say that you are having doubts about your core bond holding and want to pull some money out, but you aren’t quite sure where you ultimately want to allocate it. It could take a few weeks to do the proper due diligence and find a new fund, how can you balance your desire to move quickly with your need to make a prudent decision about the new investment? Enter the ETF.

You can sell out of the old fund and use the proceeds to purchase an ETF with similar exposure. In this case, since your old investment was in a core bond fund, you could use the iShares Core U.S. Aggregate Bond ETF (AGG). This allows you to stay invested in the market, continue your exposure to potential yield, and keep your overall portfolio asset allocation unchanged. You have just gone from one core bond fund to another. When you find that new manager you can then sell your investment in AGG and purchase the new fund. The ETF has provided you with a bridge between your old investment and your new one, and has preserved your market exposure along the way.

“But wait!” you might say, “couldn’t I use pretty much any core fund to do this, why use an ETF?” There a couple of properties about AGG that make it especially well-suited for the task. The first is that AGG is an index fund and is designed to track a specific benchmark, in this case the Barclays Aggregate Index. You can look at the fund’s 10+ year track record and see that it has done this pretty effectively over time. The fund holdings are even published every day so you can see exactly what is in the portfolio. When you are looking to use an investment for a short time period this precision is crucial. It means that you won’t be surprised if your temporary core manager suddenly decides to rebalance the portfolio to pursue a new opportunity. This may be appropriate if you trust the manager and have done your due diligence, but this isn’t the type of risk that you want to take while you are evaluating your choices. The ETF shields you from style drift.

The second key ETF property is liquidity. Individual bonds trade over-the-counter (OTC), their prices negotiated between buyers and sellers. Anytime you buy a bond, or buy into a fund that then has to buy bonds, you incur a bid-offer spread. This can make short term investments in fixed income very expensive. Conversely, bond ETFs are traded on exchanges, their prices available to all investors. Putting the bond market on the exchange generally results in lower transaction costs then trading bonds directly. In the case of AGG, it has typically traded with a spread of about 2 basis points.* As AGG is commonly used for transitions like this, along with a variety of other applications, liquidity on the exchange tends to be fairly deep. As of September 29th the 20 day average daily trading volume (ADV) for AGG was over $140 million.

In addition to AGG there are other ETFs that can serve as temporary exposure vehicles, here are some that we have had questions on recently:

For a short maturity option, we have seen interest in the iShares Short Maturity Bond ETF (NEAR). Short maturity funds are especially useful for transitions as they generally have less interest rate risk than most other fixed income funds. For this reason we see them used by investors transitioning between short maturity portfolios, and also by investors just looking to reduce market risk during their transition.

For investors seeking exposure to high yield corporate bonds, we suggest the iShares High Yield Corporate Bond ETF (HYG). Using ETFS as transition vehicles in a market like high yield is especially valuable because it can be so expensive to trade that bond market directly. HYG also offers a 1 basis point spread.*

Whatever your current strategy, ETFs can provide you with extra time as you make adjustments to your portfolio, and help you make the right decisions with your investments. And you never know, along the way you may find that the liquidity and precision benefits of the ETF make it a valuable part of your portfolio for the long term.

*Blackrock, NYSE Arca, from 8/1/2014-8/30/2014.

Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The BlackRick Blog.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency and its return and yield will fluctuate with market conditions.

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